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Is A Gap In Small-Business Credit Holding Back The American Economy?

(Editor’s note: This first in a series of articles based on a Harvard Business School working paper by Karen Mills that analyzes the current state of availability of bank capital for small business.)

Small businesses are core to America’s economic competitiveness. Not only do they employ half of the nation’s private sector workforce—about 120 million people—but since 1995 they have created approximately two-thirds of the net new jobs in our country.

They are also instrumental in driving the innovation that provides a competitive edge in the global market. Small firms produce 13 times more patents per employee than larger firms, and employ more than 40 percent of high-tech workers in America.

Why is this important? Because our nation has long relied on this engine for innovation and job creation to drive competitiveness, while also providing a path to a prosperous lifestyle for countless American families. But today, small businesses are not creating these jobs at the rate that we need.

The recession saw an unprecedented deterioration in labor market conditions. Both large and small businesses felt the sting of job losses during the crisis, but small firms were hit harder, took longer to recover, and may still be reeling from the economic fallout.

This is consistent with economic literature that tells us small businesses are always hit harder during financial crises because they are more dependent on bank capital to fund their growth and operations. They feel the swings up and down more acutely due to their reliance on the free flow of bank credit, according to a 1994 study by Gertler and Gilchrist.

Unlike large firms, small businesses lack access to public institutional debt and equity capital markets and the uncertainty of small business profits makes retained earnings a necessarily less stable source of capital. About 48 percent of business owners report a major bank as their primary financing relationship, with another 34 percent noting that a regional or community bank is their main financing partner.

Is there a credit gap for small businesses?

There is disagreement over whether there is indeed a credit gap when it comes to small business. Banks say that there is currently a lack of demand and that they can’t find enough qualified borrowers. Small business owners feel that despite being creditworthy today, banks remain either wary or entirely unwilling to lend to them.

There is no data that definitively measures either the credit gap for small business or the impact of that gap on the economy. (As part of recent financial reform legislation, the gap in small business credit data was recognized and a specific provision was included to allow for more credible monitoring for small business access to bank credit. Section 1071 of the Dodd-Frank Act amended the Equal Opportunity Act to entrust the Consumer Financial Protection Bureau with requiring banks to collect and maintain certain data in connection with credit applications made by women- or minority-owned businesses and small businesses.) However, the information that exists paints a troubling picture.

Currently, one of the most indicative metrics of the relative availability of credit is the Federal Reserve’s Senior Loan Officer Survey (SLOS). This survey shows that demand for small business loans tightened significantly in 2009 and began loosening slightly in 2010, but only at relatively low levels. By contrast, the loosening of standards for large businesses has outpaced that for smaller firms in recent years.

In addition, most major surveys of small business owners point to credit access being more difficult during the five years since the recession. The National Federation of Independent Businesses (NFIB) survey does indicate that not all small businesses have historically been pleased with their access to credit markets, even during the growth period of the late 1990s. But, this data also suggests that small businesses feel that credit access remains tighter today than in the prior recovery, with fewer small businesses reporting that their credit needs are being satisfied.

One of the most frequently cited snapshots of small business credit markets is the Federal Deposit Insurance Corporation’s (FDIC) Call Report data. According to this data, commercial bank loans on the balance sheets of banks with principal less than or equal to $1 million, which are often extended to small firms, have shown declines through the first half of 2013, and are down about 21 percent since the financial crisis.

It is important to outline some caveats on this data. First, data from FDIC Call Reports is available only for the size of the loan and not for the size of the business, so small business loans are defined as business loans under $1 million. This can be problematic when a range of larger businesses are paying down their larger loans and the outstanding value of those loans falls below the $1 million threshold. Second, this data does not measure the flow of credit to small businesses, but rather just what small business owners are actually using. For example, if a bank provides a small business with a line of credit totaling $50,000, but a small business only draws down half of that amount, Call Report data will simply report a net credit gain of $25,000. Third, the data only includes small business loans on the balance sheets of banks, not loan originations. This means that loans which have been securitized will not be counted.

The banking industry appears less focused on small-business lending

The banking industry in the aggregate appears increasingly less focused on small business lending. The share of small business loans of total bank loans was about 50 percent in 1995, but only about 30 percent in 2012. Moreover, small business owners report that competition among banks for their business peaked in the 2001 to 2006 period, and has sharply declined from 2006 to the present.

The reality is that for most banks, lending to small businesses, especially in the lower dollar range, is costly and risky. But it is these lower dollar loans that are most important to startups and small businesses.

Is the current credit environment dampening job creation?

Washington has been engaged in a debate over macro-economic issues like deficit reduction and the size of government. These are important issues, and we’ve made progress. But, if we’re going to raise the trajectory of job creation, we must focus on micro-economic strategies that give small businesses and entrepreneurs the resources they need to grow and create more well-paying jobs. One of the most critical of these is capital.

As the pace of the recovery continues to be slow, we need to ask whether the current credit environment is having a dampening effect on small business job creation, and thus, the jobs gap overall. Although there is no way to accurately measure the gap in this market, the evidence strongly suggests an imperfect market and acute impediments to creditworthy borrowers that must be addressed if we are going to accelerate job creation.

(In the next post in our series, Mills will explore both the cyclical impact of the recession on small-business lending, along with the structural issues that will continue to impede bank credit markets.)

About the author

Karen Mills is a senior fellow with the Harvard Business School and the Harvard Kennedy School focused on competitiveness, entrepreneurship and innovation. She was a member of President Obama’s Cabinet, serving as Administrator of the US Small Business Administration from 2009 to 2013.

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